Bloomberg: China to Nullify Financing Guarantees by Local Governments

A Bloomberg report out just this morning suggests there may be a lot more risk to China’s financial system than meets the eye.

Many of the stimulus projects undertaken this past year have been financed, not by the central government directly, but by local governments, including cities, counties, and provinces. For the most part, however, they have limited funds and face official restrictions on their ability to borrow directly. To circumvent these limits, they set up special investment vehicles to borrow the money instead. Because these debts are supposedly guaranteed by the local governments (meaning they would step up to pay if the immediate borrower couldn’t), banks and other lenders tend to treat the loans as essentially risk-free. Northwestern University Professor Victor Shih calculates that local governments have already accumulated RMB 11 trillion (US$ 1.7 trillion) in outstanding debt, with RMB $13 trillion (US$ 1.9 trillion) in available credit lines, belying China’s low reported levels of public debt.

Now comes news, from top regulators in Beijing, that “China plans to nullify all guarantees local governments have provided for loans taken by their financing vehicles as concerns about credit risks on such debt surges.” (According to the report, the Ministry of Finance is also drafting rules to ban local governments from issuing any more such guarantees in the future). Without the guarantees in place, Shih believes, China could face a “gigantic wave” of bad debts and halted projects.

The reason why is that many of the “special investment vehicles” set up by local governments lack the means to repay the debt themselves — their credit was worthless without the guarantee. In particular, central bank governor Zhou Xiaochuan pointed to two kinds of vehicles lay at the heart of regulators’ concern: those that have no real assets besides the guarantee, and those that use land as collateral. The former are not unlike the Asset Management Companies (AMCs) used to offload bad debts from the balance sheets of the “big four” state-owned banks, using the fig-leaf of a government guarantee to avoid any recognition of losses. I’ve been warning about the latter kind of exposure for quite some time, not just in the public but also the private sector. At best, land pledged as collateral is a relatively illiquid asset that may be of limited help in actually repaying a loan; at worst, a downturn in China’s bubbly real estate market leave the lender highly exposed.

So why are Chinese authorities announcing this move now, and what does it all mean? On one level, it’s part of a series of signals over the past few weeks designed to tamp down runaway lending. Last spring, in the midst of China’s huge lending boom, the China Banking Regulatory Commission (CBRC) was reassuring skeptics there was no reason to fear an explosion of bad debt because most loans were going into government-sponsored infrastructure projects and would almost certainly be repaid. A year later, they’re a lot more worried, and are sending a strong message to lenders that such loans should not be considered risk free. Even with the guarantees in place, Bloomberg reports that “a few cities and counties may face very large repayment pressure in coming years because of debt ratios [outstanding debt compared to annual revenue] already exceeding 400 percent.” By striking the fear of God into lenders, regulators hope to get them to turn off the tap.

Whether regulators will really leave banks holding the bag for the loans that have already been made is another matter. The government has no interest in undermining the balance sheets of the big banks, which it would be forced to bail out in any event. But I found the Bloomberg article’s allusion the 1998 collapse of Guangdong International Trust & Investment Corp. (GITIC) potentially prophetic. Besides the “big four” banks, China has literally hundreds of smaller lending institutions, from municipal banks to trust companies to rural credit co-ops. I wouldn’t be surprised if many of these institutions, with their close ties to local governments, own a big piece of the loans being called into question. It’s too early to say, but if GITIC offers any precedent, we could see a handful of less-favored institutions cut loose and allowed to implode. Depositors, creditors, and investors might be well advised to start asking, who is the next GITIC?

UPDATE: Even as I was writing this post, the Bloomberg folks were calling me up for comment. You can read the updated version of their article, which now includes a couple of quotes from me, here.

There are a lot of vital infrastructure projects that are taking the form of local investment companies. I am thinking particularly about subway projects, which I believe is a central government encouraged set of projects. Any thought about whether these types of companies (subways, tollways, etc) would be affected by this move?

Also, did you see the announcement that the Central Government is forming an asset management company (Gouxin Asset Management) to handle the companies owned by central SASAC and restructure them down to 80 or 100 from the current 128. Any thoughts?

If the situation were so dire as to pose a clear and immediate danger to the financial system, would the central government take such a drastic step to minimize the exposure to potential loss or would it do so to cause panic?

Or would the central government merely say that any local government guarantees will be void and nullified GOING FORWARD?

I’ve heard the latter, but haven’t read or heard anything about the former.

To me, this step is just another one of those precautionary measures to minimize the risk to the financial system. Nothing extraordinarily alarming.

Interestingly enough, Er-dos is again mentioned in the report. Victor Shin, the political science professor from Northwestern University who made a little fame for himself by announcing to the world that he has found China has hidden RMB X trillion local government debts, was also mentioned in the report.